Tuesday, July 10, 2007

India’s Supreme Court ruled Monday that foreign companies would not have to shell out taxes on global income earned from deals with their outsourcing units if they were conducted at market prices.

The court ruling came in a case involving Morgan Stanley’s business process outsourcing unit in India, in which revenue officials had said the company should pay taxes on its global income.

A tax tribunal had earlier exempted Morgan Stanley on the grounds that the back-office unit was not a permanent establishment of the parent company in India. The Authority of Advance Ruling said Morgan Stanley’s global profits were not taxable here as long as it paid an “arm’s length” (a price at which two unrelated parties would agree to a transaction) price to its Indian subsidiary.

Global businesses like Goldman Sachs ,Barclays, Standard Chartered, HSBC and Citigroup have outsourced operations to India to cut down on costs.

“From a legal standpoint, there’s absolute clarity with the Supreme Court ruling, which is binding on all lower courts and authorities. This is an important fact for multinationals,” says Sudhir Kapadia, a partner at advisory services giant KPMG. “If these firms can demonstrate they have arrangements at arm’s length with their captive units, no further questions should rise,” Kapadia told Forbes.com.

But there’s a catch. “What begs the question is: ‘What is arm’s length in the case of a captive BPO?’ ” he said.

India doesn’t have an advance pricing mechanism that lets companies approach officials to fix an arm’s length price for transactions in advance, Kapadia said, so, “it can take two years for a business to determine if its arrangement is at arm’s length, when audits are done by authorities.”

In its ruling, the Supreme Court said the “arm’s length” price would have to reflect all the costs and risks borne by a company’s captive unit, or it could be liable for taxes in India.

In other countries where foreign companies have outsourcing units, activities are at a nascent stage relative to India, and “we’ve not come across any serious taxation challenges,” Kapadia said. But India should have a more proactive strategy on BPO transactions, given its leadership in the sector.